Delving into the credit derivatives market: The ins and outs of credit default swaps

You may have heard of a credit default swap before. If you haven’t, then you may be a little confused to as what one is.

So what exactly are credit default swaps?

Let’s take a closer look…

What are credit default swaps?

Credit default swaps are the most popular type of credit derivative.

A credit default swap is essentially a form of insurance contract that is written on fixed-income securities. These fixed income securities include bonds.

Banks are the main issuers of these credit default swaps. They issue them to buyers of bonds and other fixed-income securities to protect them against the risk of the bond issuer going bust.

How credit default swaps work

If a buyer of bonds decides to buy a credit default swap, he agrees to pay the seller (the bank in other words) a premium. This is the equivalent of an insurance premium. The buyer must pay the premium for a specific period of time.

In the event the bond issuer goes bust, the seller of the credit default swap will pay the buyer any interest payments they’ve lost plus the money they initially invested in the bonds in the first place.

The usefulness of credit default swaps

Watching the prices of credit default swaps can be quite revealing.

Take the financial crisis in 2008. By looking at the prices of credit default swaps, it was a useful way of seeing which bank may go bust next. The higher the price of a credit default swap, the more worried the market was about the financial situation of the bank in question.

So there you have it. The ins and outs of credit default swaps.

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